How buyers use indemnities to reduce risks and manage uncertainty.
By Will Axtell, Corporate Partner at Penningtons Manches Cooper and contributor to the Rockworth Partners Network. This is an edited excerpt from Pennington Manches Cooper’s legal framework and process – Guide to Selling a Business.
What are indemnities?
An indemnity is a contractual promise to reimburse a buyer upon the happening of a specific event.
Where known liabilities are revealed to a buyer as a result of either the due diligence or disclosure exercises, it will usually require the seller(s) to give a specific indemnity (in respect of the matter concerned) in the acquisition agreement.
Indemnities are undertakings given by sellers to meet a specific potential or unquantifiable liability regarding the target company, in the context of a business sale. An indemnity obliges a seller to make a payment to the buyer if and when the liability to which the indemnity relates crystalises.
By way of example, a seller may have disclosed that the target company owns an area of contaminated land that needs to be cleaned up and the cost of doing so is unknown. The buyer may not have recourse under the warranties because the seller has disclosed full details of the problem in the disclosure letter. However, the disclosure made by the seller would alert the buyer to the fact that the circumstance exists and that it should require an indemnity to cover the cost of remediation.
From a seller’s perspective, indemnities can be onerous and so should only be offered when they are clearly needed and not, for example, for issues that would be considered to be normal business risks. Their precise scope and terms will need to be carefully negotiated.
What’s the difference between a warranty & an indemnity?
It is important for sellers and buyers to be aware of the distinction between a warranty and an indemnity.
A warranty is a contractual statement made by sellers regarding the state of the target company or business, whereas an indemnity is a promise by sellers to reimburse a buyer for a specific liability if the need ever arises.
A breach of warranty will only give rise to a successful claim if a buyer is able to demonstrate that the warranty was untrue, the seller(s) did not make an adequate disclosure in the disclosure letter and, as a consequence of the breach, it has suffered a loss in terms of the company or business being worth less than it would have been had the warranty been true.
An indemnity, however, is a contractual promise to reimburse a buyer upon the happening of a specific event, irrespective of whether a target company or business can be shown to be worth less as a result of that event.
Tax Indemnities (or Tax Covenant)
In the context of a share sale, it is conventional for a specific set of indemnities (often known as a tax covenant) to be given by sellers to a buyer to cover any historic tax liabilities of the target group. This means that sellers will generally be liable for any pre-completion tax liabilities, known or unknown, subject to an agreed set of exceptions.
For example, usually a seller will not be liable for tax liabilities provided for in the company’s accounts or which are taken into account in the calculation of the purchase price (e.g. by being provided for in a set of completion accounts).